< Back To Article List

Six Potential 401(k) Rollover Pitfalls

Posted on

You’re about to receive a distribution from your 401(k) plan, and you’re considering a rollover to a traditional IRA. While these transactions are normally straightforward and trouble free, there are some pitfalls you’ll want to avoid.

1. Consider the pros and cons of a rollover. The first mistake some people make is failing to consider the pros and cons of a rollover to an IRA in the first place. You can leave your money in the 401(k) plan if your balance is over $5,000. And if you’re changing jobs, you may also be able to roll your distribution over to your new employer’s 401(k) plan.

  • Though IRAs typically offer significantly more investment opportunities and withdrawal flexibility, your 401(k) plan may offer investments that can’t be replicated in an IRA (or can’t be replicated at an equivalent cost).
  • 401(k) plans offer virtually unlimited protection from your creditors under federal law (assuming the plan is covered by ERISA; solo 401(k)s are not), whereas federal law protects your IRAs from creditors only if you declare bankruptcy. Any IRA creditor protection outside of bankruptcy depends on your particular state’s law.
  • 401(k) plans may allow employee loans.
  • And most 401(k) plans don’t provide an annuity payout option, while some IRAs do.

2. Not every distribution can be rolled over to an IRA. For example, required minimum distributions can’t be rolled over. Neither can hardship withdrawals or certain periodic payments. Do so and you may have an excess contribution to deal with.

3. Use direct rollovers and avoid 60-day rollovers. While it may be tempting to give yourself a free 60-day loan, it’s generally a mistake to use 60-day rollovers rather than direct (trustee to trustee) rollovers. If the plan sends the money to you, it’s required to withhold 20% of the taxable amount. If you later want to roll the entire amount of the original distribution over to an IRA, you’ll need to use other sources to make up the 20% the plan withheld. In addition, there’s no need to taunt the rollover gods by risking inadvertent violation of the 60-day limit.

4. Remember the 10% penalty tax. Taxable distributions you receive from a 401(k) plan before age 59½ are normally subject to a 10% early distribution penalty, but a special rule lets you avoid the tax if you receive your distribution as a result of leaving your job during or after the year you turn age 55 (age 50 for qualified public safety employees). But this special rule doesn’t carry over to IRAs. If you roll your distribution over to an IRA, you’ll need to wait until age 59½ before you can withdraw those dollars from the IRA without the 10% penalty (unless another exception applies). So if you think you may need to use the funds before age 59½, a rollover to an IRA could be a costly mistake.

5. Learn about net unrealized appreciation (NUA). If your 401(k) plan distribution includes employer stock that’s appreciated over the years, rolling that stock over into an IRA could be a serious mistake. Normally, distributions from 401(k) plans are subject to ordinary income taxes. But a special rule applies when you receive a distribution of employer stock from your plan: You pay ordinary income tax only on the cost of the stock at the time it was purchased for you by the plan. Any appreciation in the stock generally receives more favorable long-term capital gains treatment, regardless of how long you’ve owned the stock. (Any additional appreciation after the stock is distributed to you is either long-term or short-term capital gains, depending on your holding period.) These special NUA rules don’t apply if you roll the stock over to an IRA.

6. And if you’re rolling over Roth 401(k) dollars to a Roth IRA…If your Roth 401(k) distribution isn’t qualified (tax-free) because you haven’t yet satisfied the five-year holding period, be aware that when you roll those dollars into your Roth IRA, they’ll now be subject to the Roth IRA’s five-year holding period, no matter how long those dollars were in the 401(k) plan. So, for example, if you establish your first Roth IRA to accept your rollover, you’ll have to wait five more years until your distribution from the Roth IRA will be qualified and tax-free.

 

Have questions?

We’re here to help.  Please fill out the form below and we will call you to discuss your needs.

  • This field is for validation purposes and should be left unchanged.

Disclaimer of Liability Our firm provides the information in this newsletter, on its website, and related free information distributed via email for general guidance only, and it does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.

Tax articles in this newsletter, on the Firm website, and those distributed through emails are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose

Although Hoyle, CPA, PLLC has made every reasonable effort to ensure that the information provided is accurate, Hoyle, CPA, PLLC, and its owner and staff, make no warranties, expressed or implied, on the information provided. The participant accepts the information as is and assumes all responsibility for the use of such information.

This communication is strictly intended for individuals residing in the state(s) of AL, AK, AZ, AR, AA, AE, AP, CA, CO, CT, DC, DE, FL, GA, GU, HI, ID, IL, IN, IA, KS, KY, LA, ME, MD, MA, MI, MN, MS, MO, MT, NE, NV, NH, NJ, NM, NY, NC, ND, OH, OK, OR, PA, PR, RI, SC, SD, TN, TX, UT, VT, VI, VA, WA, WV, WI and WY. No offers may be made or accepted from any resident outside the specific states referenced.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2017.

DISCLAIMER: Information provided by Hoyle, CPA, PLLC on social media, on its website, and related free information distributed via email is intended for reference only. The information is designed solely to provide guidance and is not intended to be a substitute for someone seeking personalized professional advice based on specific factual situations. Responding to such inquiries does NOT create a professional relationship between Hoyle, CPA, PLLC and participant and should not be interpreted as such. Although Hoyle, CPA, PLLC has made every reasonable effort to ensure that the information provided is accurate, Hoyle, CPA, PLLC, and its shareholders, managers, and staff, make no warranties, expressed or implied, on the information provided. The participant accepts the information as is and assumes all responsibility for the use of such information.